Defining Valuation: DCF and Other Tools, Part II

Posted: April 20, 2018

By Tom Macpherson

A version of this article originally appeared February 25, 2018 on GuruFocus.com

Failure is central to engineering. Every single calculation that an engineer makes is a failure calculation. Successful engineering is all about understanding how things break or fail.” -Henry Petroski[1]

Successful investing is as much a failure-prevention process as it is looking for undervalued growth opportunities. Great investors avoid failure (most of the time!) by understanding the elements that often lead to failure. In this second of a three-part series, I walk readers through some of the main tools in my valuation tool set. My discounted cash flow (DCF) spreadsheet tool is used to answer the five questions mentioned in Part 1. These were:

Are managers great allocators of capital? Do they use assets to drive future growth (hopefully highly profitable) over the long-term?

Does the company have the financial strength to shake off even the most severe economic or financial challenges?

Does the company have the ability to earn a return on capital greater than its weighted cost of capital over a 10-to-20-year time horizon?

Does the company have the ability to beat competitors over the same time horizon?

Is there a margin of safety? Does the stock price allow for probable and possible disappointments?

This article doesn’t cover all the tools I use. A full description would take a small book that would – with all likelihood – be a bestseller at the “American Society of Chronic Sleeplessness” annual meetings.

IRR Treasury Review (or Buffett’s “Equity Bond”)

Warren Buffett’s “Equity Bond” Theory is one of his core components when it comes to market investing. It states that companies with durable competitive advantages have earnings yields that equal or surpass government yields. I find it gives a quick snapshot of the company’s long-term economic sustaining power.

While government bonds have fixed yields, a company with a durable competitive advantage should increase every year and – within reason – drive corporate prices higher. If the company’s earnings rate of return is higher than the bond’s rate of return, you buy the stock.

Buffett’s Rate of Return formula is as follows:

% Rate of Return = (Net Income/Market Cap) x 100

Let’s use current Dorfman Value Investments holding F5 Networks (FFIV) as an example. Current net income was $421M in 2017. Total market cap was $8.8B. Dividing $421M by $8.8B equals 0.049. Multiplied by 100 = 5.0% (rounded up).

Compared to the current rate of a 10 YR Treasury note (as of April 2018) of 2.68%, FFIV meets Buffett’s idea of an “Equity Bond”

Balance sheet strength

A strong balance sheet allows a company both offensive and defensive options. In the case of a significant downturn, the company can rely on cash on the balance sheet to fund operations (defensive) or acquire undervalued competitors (offensive). I use three measures: Cash as a percent of assets, cash as a percent of liabilities, and cash used as reduction of P/E. Generally, I look for companies that have 50% or more of assets in cash and 100% or more of liabilities. This process protects me on the downside from potential blow ups that can lead to permanent capital impairment for my investors. Less than a quarter of all publicly traded companies meet these criteria.

Free cash flow (and earnings) yield

Every profitable company can calculate either their free cash flow (FCF) or earnings as a percentage of total revenue. These are referred to as FCF yield or earnings yield. The higher the number the better. In the case of my investment calculations, I like to see FCF/revenue exceed 25%. I want earnings/revenue to be 15% or higher. These types of numbers can create a buffer against the risk of rapid descent in either free cash or earnings.

Return on invested capital

Return on invested capital can be calculated in hundreds of ways. The formula I prefer to use is the following:

This calculation removes some of the numbers that can skew ROIC numbers. Companies with large goodwill or cash on the balance sheet can see ROIC be highly inflated or deflated.

Return on allocated capital

Here I’m looking to see how good management’s skill is in allocating retained earnings. There is no more important job for management than allocation of capital. It’s very difficult to see long-term profitable growth if your investment’s managers unwisely use retained earnings and cash to grow (or shrink!) the business. The formula used is below.

These are not the only profitability measures by any measure. I also look at return on equity (ROE) and return on assets (ROA). For ROIC and ROAC I look for 25% or greater. For ROE and ROA I want to see 15% or greater.

Cash return

The cash return formula measures how efficiently the business is using its capital — both equity and debt — to generate free cash flow. The formula is free cash flow + net interest expense divided by enterprise value. I generally look for a cash return of 7% or greater.

Discounted free cash flow (intrinsic value)

A discounted free cash (DCF) model uses future free cash flow projections and discounts them – using a required annual rate – to arrive at present value estimates. That present value estimate is then used to evaluate the potential for investment. There are several things that impact a DCF model – the current share price, the number of shares, current free cash flow, estimated 10-year FCF growth rate, perpetuity growth rate, and discount rate.

The first three need no description but the final three can be quite subjective. For an estimated free cash flow growth rate, I generally start by looking at the last 10 years rate, halving it, and then sometimes halving it again. I vary this discount depending on my level of uncertainty. My suggestion is that whatever number you initially come up with halve it. That’s what’s called a margin of safety!

Always assume the worst and build from there. For a perpetuity growth rate some people use 4% but I think this is too aggressive; I use 3% on average.

Finally, to calculate the discount rate I start with current 10-year Treasury rate and then add on for company size, financial leverage, cyclicality, management governance, economic moat, complexity of business and its previous weighted average cost of capital (WACC). Dependent on these factors, a discount rate can range from 7% – 13%. As I’ve stressed before, the use of a DCF model should give an estimated intrinsic value – not an exact intrinsic value. It should also demonstrate whether the current price provides an adequate margin of safety.

A Quicker Screen

For folks who are looking for a much quicker way to identify investment candidates, here is a stock screen you might want to use. You can create the following screen on your favorite stock-screening software. My favorite is the stock screen on Gurufocus.com.

Debt-to-Equity 0%

Return on Assets (10 Year) >15%

Return on Equity (10 Year) >15%

Return on Capital (10 Year) >15%

This screen will generally get you to about 150 companies or less.

As always, I look forward to your thoughts and comments.

About the author:

Thomas Macpherson is a portfolio manager at Dorfman Value Investments. The views expressed in his articles are his own and not necessarily those of the firm. He is the author of “Seeking Wisdom: Thoughts on Value Investing.”

[1] Petroski is a professor of civil engineering and history at Duke University. His “To Engineer is Human: The Role of Failure in Successful Design” (Vintage Press, 1985) is considered a classic and I recommend everyone read it at least once in their investing career.